Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options

Chapter 1. The Market Background

DERIVATIVES BUILDING BLOCKS

A derivative is an asset whose value is derived from the value of some other asset, known as the underlying. Imagine that you have signed a legal contract that, with the payment of a premium, gives you the option to buy a fixed quantity of gold at a fixed price of $100 at any time in the next three months. The gold is currently worth $90 in the world market. The option is a derivative and the underlying is gold. If the value of gold increases, then so does the value of the option, because it gives you the right (but not the obligation) to buy the metal at a predetermined price.

For example, suppose that the market price of gold rose sharply in the weeks after signing the deal and the quantity specified in the contract was now worth $150. Then you could if you wished exercise (take up) the option, buy the gold for $100, and immediately sell it on to a dealer for $150. The option contract has become a rather valuable item. Suppose, instead, that the price of gold had collapsed, and the quantity specified in the contract was only worth $50. The option would then be virtually worthless, and it is unlikely that it would ever be exercised.

Derivatives are based on a very wide range of underlying assets. This includes metals such as gold and silver; commodities such as wheat and orange juice; energy resources such as oil and gas; and financial assets such as shares, bonds and foreign currencies. In all cases, the link between the ...