Derivatives: Valuation and Risk Management

By David A. Dubofsky; Thomas W. Miller Jr. | Go to book overview
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CHAPTER 1

An Overview of Derivative Contracts

A derivative is a financial contract whose value is “derived from,” or depends on, the price of some underlying asset. Equivalently, the value of a derivative changes when there is a change in the price of an underlying related asset. This chapter provides a broad overview of the four classes of derivative contracts: forwards, futures, swaps, and options. However, because forwards, futures, and swaps are very similar types of contract, many believe that there are really only two types of derivative: options and forwards. While other derivative contracts exist, a careful analysis of their characteristics will reveal that they are merely variations of one (or more) of these major classes.

Mark Rubinstein (1976) was perhaps the earliest author to use “derivative” in a financial contract context; in this particular article, he used the term to refer to options. A computerized search found that it wasn't until 1981 that an article in the popular press Business Week (1981) used the term, with quotation marks around it. This article expressed the fear that trading in options and futures (derivatives) detrimentally affects the markets of the underlying assets. It also raised the issue of who—the Securities and Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC)—should regulate trading in derivatives. Currently, “derivatives” is routinely used in business communication and all forms of media, and textbooks and college courses are devoted to the study of the subject.

Individuals of many types use derivatives. Speculators who think they know the future direction of prices use derivatives to try to profit from their beliefs. Arbitrageurs trade derivatives to take advantage of times during which prices are “out of sync”: that is, one asset or derivative contract is mispriced relative to another. Hedgers face the risk that a change in a price will hurt their financial status; they use derivatives to protect, hedge, or insure themselves against such harmful movement in prices. Of particular interest is the current indispensability of derivatives for accomplishing many tasks necessary to the successful management of corporations, governments, and large pools of money in general: managing exposure to price risk, lowering interest expense, altering the structure of assets, liabilities, revenues, and costs, reducing taxes, circumventing unwieldy regulations that make transactions difficult, and arbitraging price differentials.

We can characterize derivatives by the structures of the markets in which they trade. Some derivatives trade on organized exchanges. In particular, there are options and futures exchanges in existence all over the world.1 These exchanges allow virtually anyone who meets some set of financial criteria (e.g., the individual's net worth or income) to trade these contracts. Price and trade information are readily available, and at any point in time, the prices at which they can be bought do not appreciably differ from the prices at which they can be sold. Other derivative contracts actively trade in liquid and well-established over-the-counter (OTC) markets. These markets are open only to large, financially sound corporations, governments, and other institutions.

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