Basis Instrument Contract

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In financial derivatives analysis, a Basis Instrument Contract or BIC is a representative derivative contract that is an element of a set of classes of equivalence of contracts. Together, these contracts uniquely enable the static replication of any derivatives contract in a multi-period trading market without any model assumption.

Hence, BICs are derivatives contracts of reference through which any derivatives contract, however complex or illiquid can be decomposed. This absence of model assumption is the critical differentiating factor with the Black Scholes Merton replication method by continuous delta hedging or more generally, the derivatives hedging approach by greeks hedging. The characteristic features of BICs and the rationale for those are as follows:

1) A Basis Instrument Contract or BIC identifies two parties: one or more buyer(s) named A and one or more seller(s) named B.

2) The definition of each BIC comprises three dates:

• The contract agreement date t0, which is the date at which the binding rights and obligations on both sides of the contract are agreed upon.

• The premium payment date ti , which is the date at which the party identified in the contract as the buyer A complies with its part of the agreement by paying the seller B an amount in units of basis currency known as the premium of the contract or the premium payment amount. The premium payment amount may be expressed as a function of the values of the fluctuating variables between time t0 and time ti

• The contract expiry date, also known as maturity or payout payment date tj, with tj > ti = ti+1, is the date at which the party(ies) identified in the contract as the seller(s) B complies with its (their) part of the agreement by paying the buyer(s) A an amount in units of basis currency as determined as the payout of the individual BIC.

3) A BIC admits notional amounts that may be functions of the realized values of underlyings and related derivatives contracts whose value shall be known by the premium payment date ti at the latest. With their pre-agreement features, BICs may be somewhat reminiscent of Forward Rate Agreements (FRAs) and Forwards. However, unlike FRAs or forwards, we do not know in general the numerical value of the notional of a BIC at contract agreement time.

BICs extend and generalize the Arrow-Debreu model's instrument of Arrow Debreu security in financial economics.