Chapter 1:Introduction:Derivatives securities

A derivative (or derivative security) is a financial instrument whose value depends on the values of
other, more basic underlying variables.
Very often the variables underlying derivatives are the prices of traded securities.
The standard derivatives: * Forward contracts
Futures contracts
Options
Swaps
1. Forward contract is an agreement to buy or sell an asset at a certain future time for a certain
price. It is not normally traded on exchange.
Long position VS. Short position
A forward contract is settled at maturity. A forward contract is worth zero when it is first entered
into, Later it can have positive or negative value.
The forward price for a certain contract is defined as the delivery price which would make that
contract to have zero value. (Risk-free arbitrage).

Example
In general, the payoff from a long position in a forward contract on one unit of asset is S T-K, where
K is the delivery price and ST is the spot price, and it is K-ST for the short position.
Example Forward price
Spot price of gold is $300 per once, one year risk free rate is 5%. Assume the 1-year forward price is
$340. Risk free profit?
Borrow $300 at 5% for a year, Buy one once of gold, enter in F-contract. Profit?
2. Future contracts
It is an agreement between two parties to buy or sell an asset at a certain time in the future for a
certain price. Unlike forward contracts, they are traded at the exchange. (SAFEX).
One way in which a futures contract is different from a forward contract is that an exactly delivery
date is usually not specified.
3. Options
They are two basic types of options, a call option and put option
A call option gives the right (not the obligation) to buy the underlying asset by a certain date for a
certain price.
A put option gives the holder the right(not the obligation) to sell the underlying asset at by a certain
date for a certain price.
Strike price or exercise price.

American options can be exercised at any time up to the expiration date, European options can only
be exercised on the expiration date.
Example
Option price
Option positions
There are two sides to every option contract. On one side is the investor who has taken a long
position (Bought the option), on the other side is the investor who has taken a short position (Sold or
written the option). The writer of an option receives cash up front but has potential labilities later.
His or her profit or loss is the reverse of that for the purchaser of the option.
Type of traders: Hedgers (reduce risk), Speculators, Arbitrageurs

4. Types of Traders
- Hedgers, are interested in reducing a risk they are already facing, ex. Exchange rate risk.
- Speculators, wish to take position in the market. Either they are betting that price will go up or they
are betting that it will go down.
- Arbitrageurs, involve locking in a riskless profit by entering simultaneously into transaction in two or
more markets.
Ex. Stock sells at $172 in New York and 100 in London at a time the exchange rate is $1,75 a pound.
Financial mathematics
Consider an amount A invested for n years at an interest rate R per annum, if the rate is compounded annually, the
FV is
A1 R

If it is compounded m times per annum, the FV is

A 1

R m
.
m

The limit of A 1

R m
. as m tends to infinity is known as continuous compounding , the FV is Ae Rn
m

Equivalent rate
Suppose that Rc is a rate with continuous compounding and Rm is the equivalent rate with compounding m times
per annum.

m
m

= AeRc

Assume Rc is given what is R m ?