Derivatives
Lecture 10

Agenda
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Introduction Forwards Futures Swaps Options

Derivative securities: Introduction

Definition of derivative securities
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A derivative is a contract to buy or sell something in the future, namely the underlying. A derivate is also known as a ‘contingent claim’, because its value is contingent on characteristics of the underlying security. All contract details (such as the price, the quantity to be bought or sold, the maturity, etc.) are fixed at the time you enter the contract. The price of the derivative depends on the underlying. The underlying can be everything as long as it is clearly defined! Examples:  Financial prices: stocks, bonds, stock-indices, exchange rates  Commodities: oil price, gold, copper, coffee, orange juice concentrate, wine, energy In most cases the underlying is the price of a traded asset!

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Derivative securities: Introduction

Types of derivatives
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Forwards Futures Options Swaps Advanced products
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Structured products: combinations of forwards, swaps, and options Hybrid debt: straight debt with embedded derivative instruments Exotic options Real options …
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Derivative securities: Introduction

Derivatives markets
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Over-the-counter markets
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non-standardized products; tailor made contracts telephone or electronic trading relative high transaction cost relative high credit risk/default risk illiquidity standardized products trading floor (open outcry system) or electronic trading relative low transaction cost virtually no credit risk/default risk liquidity
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Exchange-traded markets
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Derivative securities: Introduction

Purpose of derivatives
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Derivatives can be replicated by buying or selling the underlying asset and borrowing and lending money. Derivatives are normally issued on the