Contemporary Finance

6Derivatives Values and Risks

Derivative asset values are determined to a large extent by the benchmarks they are based on or by their underlying prices. They have payoffs in the future, so their values are also driven to some extent by interest rates.

Futures, forwards, and swaps have a linear, one-for-one response to changes in the values of the asset, index, or interest rate on which the contract is based and permit static hedging of an exposure. They can be hedged with a one-time trade in the underlying asset and can be used as a hedge with relatively straightforward management. Options, with their nonlinear changes in value, require dynamic hedging. Repeated trades are needed to stay hedged or keep an exposure within desired limits.

This implies other basic differences:

• The values of futures, forwards, and swaps are driven by the underlying price alone, not its volatility. The value of an option is driven by the volatility or tendency to fluctuate of the underlying, as well as its level.
• In any derivatives contract, the payments or assets each counterparty is bound to deliver in the future has a present value, and the difference is the net present value (NPV) of the derivative. Futures, forwards, and swaps can have an NPV of zero, at least initially, and no money necessarily changes hands at initiation. In an option, one party to the contract inevitably has a contingent, time-varying obligation to the other and has to be paid a premium at initiation.

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