The Origins and Growth of the Market
A derivative is an asset whose value is derived from that of some other asset, known as the underlying.
As an example, suppose you agree a contract with a dealer that 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 spot market. (A spot market is where a commodity or financial asset is bought or sold for immediate delivery.)
The option contract is a derivative and the underlying asset is gold. If the value of gold increases then so too does the value of the option, because it gives you the right (but not the obligation) to buy the metal at a fixed price. This can be seen by taking two extreme cases. Suppose that soon after the option contract is agreed the spot value of the gold specified in the contract rises to $150. Alternatively, suppose the price collapses to $50.
• Spot Price Rises to $150. If this happens you can exercise (take up) the option, buy the gold for $100 via the option and then sell the gold at a profit on the open market. The option has become rather valuable.
• Spot Price Falls to $50. It is much cheaper to buy the gold in the spot market than to acquire it by exercising the option. Your option is virtually worthless. It is unlikely that it will ever be worth exercising.
As discussed in Chapter 8, because an option contract provides flexibility (it does not have to be exercised) an initial fee has ...