The Basics of Financial Derivatives
9 Pages Posted: 21 Oct 2008
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The Basics of Financial Derivatives
The Basics of Financial Derivatives
Abstract
This note describes the basic elements and pricing of financial derivatives. Financial derivatives are contracts whose value is derived from the value of some other underlying asset, such as a share of common stock, a commodity (e.g., coffee, oil, or wheat), or a bond. Each derivative has its own special features and provisions, and each is used for a special financial purpose.
Excerpt
UVA-F-1258
THE BASICS OF FINANCIAL DERIVATIVES
This note describes the basic elements and pricing of financial derivatives. Financial derivatives are contracts whose value is derived from the value of some other underlying asset, such as a share of common stock, a commodity (such as coffee, oil, or wheat), or a bond. Each derivative has its own special features and provisions, and each is used for a special financial purpose. Derivatives are often used to hedge or provide risk reduction to investments, to lessen risk exposure to foreign exchange rates, to protect against movement in interest rates and, for risk-seekers, to speculate in stocks, bonds, and commodities. Derivatives are sometimes traded with the underlying asset they are based on, but they also trade as separate instruments on their own. They may trade on the large exchanges, such as the New York Stock Exchange (NYSE), or on specialized exchanges, like the Chicago Board Options Exchange (CBOE).
As you work through this note, you will learn more about the fundamental features of today's most commonly used derivatives: call and put options, warrants, swaps, convertible securities, and forward and futures contracts.
Options
One common type of derivative is a call option. A call option is a contract conveying the right to buy a specific asset (the underlying asset) at a specified price (the exercise price or strike price) over a specified period of time. Such a contract is an agreement between two parties, the buyer and the seller (sometimes called the writer) of the call option. For example, an investor holding a call option on IBM stock with a strike price of USD115 and a maturity date of June 1999 has the right to buy a share of IBM stock for USD115 on or before June 18, 1999 (conventionally, the maturity date on stock options is the third Friday of the month). If an option contract stipulates that the buyer may only exercise the option on the day that it expires (the maturity or expiration date), it is called a European option. If the buyer may exercise on any day during the option's time period, it is an American option. A buyer is free to sell the option to another party prior to maturity regardless of whether the option is American or European. Thus, exercising an option and selling it are two distinct activities.
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Keywords: option valuation, derivatives
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