Explain It Out LoudPlain English

A four-sentence template that fits every instrument on this site, twelve products written out in it, and a drill for finding the one sentence you cannot yet say.

11 min read · 1 967 words

The template

• Sentence 1 — who wants what. Every instrument exists because two parties wanted opposite things badly enough to write it down. Name both of them.
• Sentence 2 — what the contract obliges, and when. Not the payoff diagram: the obligation. Who must do what, on what date, whether or not they want to by then.
• Sentence 3 — where the money comes from. Coupon, dividend, spread, premium, the difference between two prices, a fee charged by somebody in the middle. If you cannot name the source, you have described a hope rather than an instrument.
• Sentence 4 — what makes it lose. The ordinary way, not the dramatic one. Most products lose money through their dullest mechanism.

Twelve, written out

Common stock

• A company wants money it never has to repay; an investor wants a share of whatever the business is worth in future.
• The company owes the shareholder nothing at all — no interest, no repayment date, and no promise of a dividend — beyond a vote and a claim on whatever is left after everybody else has been paid.
• The money comes from the company's future profits, distributed as dividends or retained and reflected in the price somebody else will pay.
• It loses when those future profits turn out smaller than the price assumed, and it loses everything when the company fails, because “what is left over” is usually nothing. Full page · plainer still

Government bond

• A government wants to spend before it has collected the tax; a saver wants a known amount of money on a known date.
• The government is obliged to pay a fixed coupon on fixed dates and the face amount at maturity, regardless of what has happened to it in between.
• The money comes from the coupon, plus the difference between what you paid and what you get back.
• It loses in real terms when inflation outruns the coupon, and it loses in price terms when market yields rise — a fixed payment is worth less once better-paying alternatives exist. Full page

Corporate bond

• A company wants to borrow at a lower cost than a bank charges; a lender wants more than a government pays and is prepared to look at a balance sheet for it.
• The company is obliged to the same fixed schedule as a government — with the difference that it can run out of money, and the obligation then goes into a queue.
• The money comes from the coupon, which contains both the rate a government would pay and a spread for the risk that this issuer will not.
• It loses in two separate ways that can happen at once: rates rise, or the market decides the spread was too thin. Full page · the spread part

Equity option (a call)

• A buyer wants exposure to an upward move without committing the full price; a seller wants to be paid now for accepting the obligation to deliver later.
• The buyer may buy the underlying at the strike until expiry and can walk away; the seller has no such choice — if the buyer exercises, the seller must deliver, at whatever the market price then is.
• The buyer's money comes from the underlying rising past the strike by more than the premium paid; the seller's comes from the premium, and that is all they will ever make.
• The buyer loses to time and to falling volatility even when the direction was right — which is why an option can lose on a day the underlying rose. Full page · plain-words version

Interest rate swap

• One party has a floating-rate obligation and wants certainty; another wants the opposite, or is being paid to take the other side.
• For an agreed term, one side pays a fixed rate on a notional amount and the other pays a floating rate on the same notional — the notional itself never changes hands.
• The money is the net difference on each payment date, which is small relative to the notional and is why the notional is a bad measure of the risk.
• It loses when rates move against your side, and the loss is amplified by the term: a ten-year swap moves several times as much per basis point as a two-year one. Full page · how much, per basis point

Repo

• One party has securities and needs cash overnight; another has cash and wants it back tomorrow with as little risk as possible.
• The securities are sold and simultaneously agreed to be bought back the next day at a slightly higher price — legally a sale, economically a secured loan.
• The money is that price difference, which is the interest rate, plus the haircut protecting the cash lender against the collateral falling.
• It goes wrong when the collateral falls faster than the haircut allowed, or when everybody wants cash on the same morning and nobody will lend against anything. Full page · haircuts

ETF

• An investor wants a whole index cheaply and tradeably; a provider wants a fee on assets that require little decision-making.
• The fund holds the index constituents (or a swap that replicates them), and authorised participants may create and redeem fund shares in large blocks against the underlying basket.
• The investor's money comes from the index; the provider's comes from an annual fee, plus in some cases securities lending revenue.
• It loses whenever the index does, and it under-delivers quietly through fees, tracking difference and tax on dividends — which is usually why a fund's return differs from the index it names. Full page · the gap, explained

FX forward

• An importer knows they must pay in a foreign currency in three months and wants the price fixed today; a bank is prepared to fix it because it can hedge the position with two deposits.
• Both sides are obliged to exchange the two currencies on the agreed date at the agreed rate, whatever the spot rate has become by then.
• There is no premium: the forward rate simply builds in the interest-rate difference between the two currencies, which is arithmetic rather than a forecast.
• The importer “loses” only in the sense of regret — if spot moves in their favour they are locked out of it, which is the price of having known the number three months early. Full page · hedging

Credit default swap

• A lender wants to keep a bond but not the risk that its issuer defaults; a seller of protection believes that default is less likely than the market is charging for.
• The buyer pays a regular premium for a fixed term; the seller is obliged to make the buyer whole if a defined credit event happens to the named issuer.
• The seller's money is the premium stream; the buyer's is the payout, which arrives exactly when everything else they own is also having a bad week.
• The seller loses suddenly and in size — this is an instrument whose losses are not gradual, which is why the position size matters more than the premium does. Full page

Autocallable note

• An investor wants a high headline coupon in a market that is not paying one; a bank wants to buy volatility cheaply from a customer who is not thinking of it as a sale.
• The note pays a coupon and redeems early if the underlying is above a level on an observation date; if it is below a lower barrier at maturity, the investor receives the fallen underlying instead of their money.
• The coupon comes from the option the investor has sold without being told they sold one — it is the premium, repackaged as income.
• It loses in exactly the scenario it was bought to avoid: a large fall, at maturity, with no early redemption to rescue it. Full page · why the protection did not protect

Money market fund

• A company or a saver wants a bank account that pays a market rate; a fund manager wants scale on an instrument that requires very little judgement.
• The fund holds very short-dated instruments — bills, repo, commercial paper — and offers daily dealing at, or very close to, a constant price.
• The money is the yield on those instruments, less a fee, and the yield tracks the central bank's rate closely.
• It goes wrong when everyone redeems at once and the underlying instruments cannot be sold fast enough at their marked prices — a run on something that was described as cash. Full page

Stablecoin

• A crypto trader wants a dollar that settles at any hour; an issuer wants to hold the reserves and keep the interest they earn.
• The issuer promises to swap a token for a dollar on demand, and holds — in the honest designs — short-dated government bills against every token in circulation.
• The issuer's money is the yield on those reserves, since the token itself pays the holder nothing.
• It breaks not usually because the reserves are bad but because redemption is temporarily unavailable, at which point the token trades wherever the secondary market says. Full page · is it stable

Practise it: one instrument, sixty seconds

The drill, on paper

• Pick a product you think you know. Set a timer for sixty seconds and say the four sentences out loud, without notes. Recording yourself is unpleasant and works.
• Find the sentence you hurried. There always is one. For most people it is sentence three — where the money actually comes from — because that is the sentence marketing material never contains.
• Then read only the part of the page that fixes it, and say the four again. This is faster than re-reading the whole page and it is the only part that changes anything.
• Move outward by one step. Once ten products are fluent, do the same for a mechanism — leverage, liquidity, volatility — where sentence one becomes “who needs this and why” and sentence four becomes “when does it stop working”.
• Then do it for a failure. Take any case study and tell it in three: what the position was, what moved, why the exit was not available. That is the shape of every one of them.

Two things that make an explanation worse

• Starting with the payoff diagram. It is the last thing to say, not the first: a diagram describes the outcome and hides the obligation, and the obligation is the instrument.
• Reaching for the exotic case. If the ordinary version is not yet fluent, the unusual one is decoration. Nobody has ever been marked down for explaining a plain instrument completely.