Derivatives: Valuation and Risk Management

Derivatives: Valuation and Risk Management

Derivatives: Valuation and Risk Management

Derivatives: Valuation and Risk Management


Derivatives: Valuation and Risk Management deals with the four primary types of derivative contracts: forwards, futures, swaps, and options. It avoids extensive and difficult mathematics, and instead focuses more on intuitive understanding on how to value each contract, and how to compute the relative price. In addition, it shows how each contract can be used to manage financial price risk. Professionals do not take the time to compute prices, values andother relevant variables. They use software. The book incorporates a widely used software package: FinancialCad in the text. After studying an example, it porceeds to show how FinancialCad solves the same problem. This is important, because software users should not use products iwthout understanding whatwent into the model that produced the solution. By first reading a specific example, they will be able to use FinancialCad with greater confidence.


We are all in the thick of a financial revolution. Over the past 25 years, the use of financial derivatives to manage risk has evolved from an exotic practice to a commonplace occurrence. This explosive growth in derivative securities mandates that all financial managers acquire a working knowledge of these important risk management instruments. Although this book is intended for a wide range of readers, it is more than just an introduction to derivative financial securities. A first reading of this book will yield a strong working knowledge of derivative securities. A mastery of the material, however, will guarantee a thorough understanding of the substantive elements in the burgeoning field of financial derivatives.

In this book, we concentrate on four classes of derivative security contracts. These classes are forward contracts, futures contracts, swap contracts, and option contracts. The focus of this book is on using forwards, futures, swaps, and options to manage price risk. However, it is important to realize that calculating the value of a derivative is also a crucial component of risk management. Fortunately, the field of finance has just the right paradigm to allow us to study how competitive markets set prices for derivative securities. Throughout this book, we detail the use of the 'absence of arbitrage' paradigm to calculate these prices.

Studying derivative securities can often be nettlesome because the material demands that the reader have a solid understanding of concepts in several fields, namely: finance, economics, elementary probability and statistics, and, of course, mathematics. For example, in writing this book, we have assumed that the reader is familiar with basic financial topics such as the term structure of interest rates, the workings of equity and fixed income markets, and the time value of money. Then, to understand the valuation of derivatives and their use in risk management, the student of financial derivatives must be able to mix these concepts with intuition and the “absence of arbitrage” paradigm.

Undeniably, the valuation concepts presented in this book are essential underpinnings for risk management. However, the actual process of valuing derivatives, especially as they grow in complexity, is also important. Although most textbooks on derivative securities use software to help the reader understand the vagaries of these markets, we provide a unique opportunity to acquaint readers with a software product used by practitioners, FinancialCAD.*

*The software described in this book is furnished under a software license agreement. The software may be used or
copied only in accordance with the terms of the agreement. Information about the software is subject to change
without notice, and FinancialCAD and Oxford University Press MAKE NO WARRANTIES, EXPRESS OR
IMPLIED, IN THIS DOCUMENT. Software copyright notice: Copyright © 1991-2002 FinancialCAD Corpora
tion. All rights reserved. FinancialCAD® and Fincad® are registered trademarks of FinancialCAD Corporation.
Other trademarks are the property of their respective holders.

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